Finding tomorrow’s ESG leaders

Finding tomorrow’s ESG leaders

Environmental, social, and governance (ESG) as a source of investment alpha may be limited when focussed solely on companies displaying ‘best in class’ ESG characteristics. Evidence shows there’s equal, if not greater, benefit in finding companies that are actively improving their ESG credentials. Their ESG scores may be ‘less than stellar’ at the time of investing, but there is a strong correlation between companies that are improving their ESG and their investment returns over that same period and beyond.

This idea might be controversial among some investors who have fixed views that to qualify as an ESG investment, the company must have already ‘arrived’ as a force for good. This begs the question:

CAN WE AGREE ON ESG?

A challenge for financial advisers and investors alike is that everybody has their own ideas about ESG – ask 10 different investors to define ESG and you’ll almost certainly get 10 different answers from them.

This lack of consistency even extends to the established and highly-regarded ESG rating agencies, who often show vastly different views when assessing the same criteria. Using the Tesla stock as an example, Chart 1 shows variation in the ESG assessment by some of the most influential rating companies in this space:

ESG is a particularly broad and fluid concept. While many ESG discussions revolve around sustainability and the environment, even something like tax can be an ESG issue, according to sustainability leaders UK-based ESG specialist WHEB Asset Management LLP.

WHEB (which also manages the Pengana WHEB Sustainable Impact fund) says company attitudes to tax can tell you a lot about management quality and about how a company’s senior leadership sees the world.

Companies that spend an inordinate amount of time and money on elaborate structures to avoid paying tax may be falling short of their social obligations – one of the key factors in ESG. As a general rule, WHEB prefers to invest in companies that have a greater focus on growing superior businesses than on creative tax planning.

What is beyond doubt is the growing popularity of ESG investments which have surged over the last two years; and investors increasingly want to know that the companies they are investing in are doing the right thing by the planet, by their people, and behaving responsibly.

Admittedly, these motives are not always purely altruistic. Investors understand that well-run sustainable companies, which prioritise their employees, the environment, and the communities in which they operate are more likely to grow and profit, particularly those which are poised to benefit from decarbonisation.

WHERE DOES ESG HAVE THE MOST POWER?

It’s worth considering ESG’s influence at different subcomponent levels i.e. the E (environmental), S (social), and G (governance). In recent years social factors have outperformed meaningfully relative to governance and environmental factors, particularly in the US.

Social has been the biggest outperformer because people are key assets for many structural growth businesses. Once improvement areas are identified, changes are often quickly implemented and results may follow quickly.

For example, companies may be able to enjoy ‘quick wins’ on social factors by implementing training or mentorship programs and more progressive employment policies, which quickly attract higher calibre employees. From an analyst’s perspective, this will reflect in higher social scores.

By contrast, environmental improvements generally take much longer to implement, and often involve short-term costs associated with changing business practices. While businesses are increasingly targeting net carbon neutrality from their operations, these objectives are generally longer term so it is more appropriate to assess the business impact over a longer time horizon. As such, the results will take longer to reflect in the data.

Governance is often glossed over as investors’ gaze is drawn to the big environmental and social wins from ESG approaches. Yet governance is critical to an ESG company’s performance. While implementing good governance can deliver benefits relatively quickly, addressing a bad governance reputation may take considerable time.

IT’S NOT JUST QUALITY

Another misconception is that ESG criteria are synonymous with the common ‘quality factors’, which often include things like strong company balance sheets, low debt, high margins, high repeat earnings, and so on.

Research conducted by MSCI has shown companies scoring well on ESG factors have outperformed companies scoring well on quality factors, while other studies have found combining both to be a stronger predictor of long-term outperformance.

US-based Axiom Investors, managers for the Pengana International Ethical range of funds, who have practiced ESG investing for over 24 years, favour the combined approach. They have found companies which improve their ESG characteristics, particularly those going from ‘laggard to leader’ tended to outperform on a total shareholder basis, even when compared to sustained ESG leaders.

THE ESG SPECTRUM DOESN’T TELL THE WHOLE STORY

While there are valuation opportunities right across the ESG spectrum, not everybody will agree on how broad the spectrum actually is. Some investors only equate ESG investments with true ‘impact’ strategies, which drive measurable positive change at the sharp end of the spectrum.

Yet the investment universe for true impact funds is limited and probably excludes at least 80% of all listed companies in the world. These strategies are accordingly niche, and the returns will be highly differentiated from broad benchmarks.

Most ESG funds seek a broader investment universe, screening out the worst offenders, such as heavy polluters, and applying positive screens toward companies with strong ESG performance.

But it’s also important to remember that not all ESG leaders started out that way. In five or 10 years we will see companies who are not currently on the spectrum transform into ESG investments, possibly even ESG leaders.

Those savvy investors who can identify tomorrow’s ESG companies today can generate considerable alpha opportunities to their portfolios.

FINDING TOMORROW’S ESG COMPANIES TODAY

Recent research published by Rockefeller Asset Management (RAM), found the market tends to overvalue ESG leaders, while undervaluing companies that are in the process of improving their ESG footprint (see Chart 2).

RAM found the top-quintile ESG improvers outperformed the bottom quintile by 3.8% annualised among US all-cap equities from 2010 – 2020.

Alliance Bernstein also analysed MSCI’s ESG data, and found companies receiving ESG rating upgrades outperformed an equal-weighted MSCI ACWI index during the following 12 months by 0.93%, while stocks that were downgraded lagged.

Finding differences between price and value is widely accepted as a cornerstone of an effective investment strategy – likewise, investing in businesses that are committed to improving their ESG footprint can reduce the risk of over-paying.

Outperformance is not necessarily driven by great companies improving. Instead, companies that were previously poorly ranked from an ESG perspective but subsequently displayed significant improvements generated the strongest outperformance over the following 12 months.

Consider Amazon – marked down on ESG due to its social and governance factors. But Amazon is making significant improvements, particularly regarding labour practices and renewable energy.

While Amazon is not an outstanding, best-in practice ESG target, it may justify a small allocation based on the performance potential from its ESG improvements.

An ESG investment portfolio may then contain companies across the ESG ‘maturity’ spectrum: for example, the Pengana Axiom International Ethical fund holds a mix of ESG stocks ranging, from ESG leaders with strong ESG practices, to companies who are improving their ESG practices – where the ESG improvement is a noteworthy returns driver and/or risk mitigator for the enterprise.

ESG investment managers may also use the opportunity to engage further with company management to ensure agreed milestones are being met. Improving ESG practices have the potential to increase brand value, enhance customer and employee loyalty, reduce costs (including the cost of capital), and create long-term competitive advantages.

This will not only help companies change for the better but also deliver attractive returns to investors.

Active equity investors can identify these opportunities through fundamental research and by engaging with companies that are accelerating ESG improvements before they are reflected in the ESG scores and valuations, or by investing with an investment manager that follows these principles and whose process includes finding companies with these characteristics.

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